Do Personal Loans Affect My Credit Score?March 01, 2022
A personal loan can help and hurt your credit score, depending on how you manage it. In the short term, taking out a loan may temporarily lower your credit score and make it more challenging to obtain additional credit. On the other hand, it might boost your credit score if you make your payments on time in the long term. Therefore, always research your options before you apply for a loan.
When Applying For a Personal Loan, Is There a Hard Check?
The lender will run a credit check on your credit report when you apply for any personal loan. When this happens, your credit score will lower by a few points. A soft credit check occurs when you receive a pre-approved offer from a lender; however, this check will not affect your credit score.
Be mindful if you are applying for many different loans at once, as it gives lenders the impression you’re a high-risk customer who is in a vulnerable financial position. Research and shop around before applying for a personal loan to ensure you are highly likely to be approved.
Can Personal Loans Help Improve My Credit Score?
You can improve your credit score in the long term by contributing to your affordability and helping you build a favourable credit history.
Your credit mix refers to the different credit accounts you have; credit cards, loans, mortgages, etc. Lenders need to see that you have managed your credit responsibly, made payments on time, and followed the terms of your loan. This will tell the lenders that you are a responsible borrower. This, in turn, will also help build your credit score.
While a personal loan won’t directly factor into your credit utilization ratio if you use it to pay off a credit card, this can lower your credit utilization ratio. We refer to this type of loan as debt consolidation, and it can help you manage your debt and improve your credit over time.
How Can a Personal Loan Harm My Credit Score?
Here’s a breakdown of how a personal loan might hurt your credit score, primarily if it’s not managed correctly:
Creating a hard check on your credit report
The lender will create a hard check on your credit report whenever you apply for a personal loan. This lowers your credit score by a few points, but the dip in your score should only last for a few months. However, multiple hard inquiries can cause more damage to your score. Therefore, it is essential to understand your credit score and report before applying and minimize the number of applications you make.
In general, if you already have a healthy credit score and a history of timely payments, it will lessen the impact of a hard check on your credit score.
Taking on more debt
When you take a personal loan, you incur more debt. Therefore, using a personal loan to pay off high-interest debt, such as credit cards, may make sense. However, you will need to make sure you change your spending habits and debt management plans too so that you don’t end up in the same position with a poor credit status.
Missed payments and additional fees
It would be best to cover the regular repayments on your loan as per your loan agreement. If you miss a payment, not only will your credit score suffer, but the lender may charge additional fees. In addition, creditors will report you to credit bureaus for all missed payments. Finally, the regular missed payment will result in a default on your loan, which will cause significant damage to your score and makes it more challenging to get credit in the future.
My Credit Score Is Fair, So Would I Qualify For a Personal Loan?
In Canada, a credit score ranges between 300 and 900:
Poor – between 300 and 574
Below average – between 575 and 659
Fair – between 660 and 712
Good – between 713 and 740
Excellent – between 741 and 900
With a fair or above score, you’ll have access to loans from banks. If you have a high score, you’ll have more options for lenders with lower interest rates.
You will have difficulty accessing a personal loan with below-average or poor credit, but it is not impossible. You can find lenders specializing in lending to those with below-average credit, but be wary of these as their interest rates can be up to 30% because the lender views you as a high-risk customer.
Bear in mind that some lenders will look at factors other than your score when deciding to approve you for a loan. For example, they may consider your income, bank balance, or employment history.
Is a Personal Loan Used For Debt Consolidation Harmful to My Credit Score?
A popular option to consolidate your debt is to take out a personal loan. When used correctly, debt consolidation can improve your credit and help pay off your debt sooner by lowering your interest rate and reducing your monthly payments. An added benefit is that it’s easier to manage one payment on one loan than multiple payments for all your loans or credit cards.
Applying for a personal loan will cause a temporary dip in your credit status; therefore, it can also make it harder to access other sources of credit in the near future. For example, if you apply for a mortgage shortly after applying for a personal loan, you may be rejected because the lender will see you have more debt than you can manage.
Over time, your credit score should recover and even improve by making all your payments on time.
When Are Personal Loans Considered In Other Circumstances?
A personal loan is the most common and effective way to consolidate high-interest debt, such as credit card debt. Other circumstances where a personal loan can be helpful are to finance a significant expense such as home improvements or a wedding or to resolve a high-cost emergency.
Personal loans can negatively impact your credit score in the short term and can also help build your score over the long term. Ensure you have a good understanding of your credit status and try to improve it (if needed) before applying for a loan. Monitor your score regularly and practice healthy credit management to improve your credit over time.